From the
beginning of commercial activity, merchants have attempted to
determine the profitability of their activities. Rudimentary
accounting principles arose to facilitate this attempt at profit
measurement. Luca Pacioli, a Venetian of the thirteenth century
is regarded as the father of accounting. Pacioli is noted for the
development of the double entry bookkeeping system, known to
first-year accounting students as debits and credits. However,
Pacioli is also credited with the origins of cost accounting.
While not focusing on the manufacturing cost aspect, Pacioli did
develop a concern for cash budgeting and variance accounting.(1)

As enterprises began to
embark on production activities, a new extension in the area of
accounting was required. This extension was the development of
cost accounting principles for manufacturers. Along with these
new principles came problems that cost accountants wrestle with
today, including problems such as accounting for the overhead
incurred in the production of the product. Absorption costing and
its alternative, variable costing, were developed to fulfill this
need, becoming the primary method of accounting for product costs.
Under this approach, a rate is determined by which a portion of
the fixed and variable factory overhead costs are applied to the
cost of each unit. This can be done in one of three ways: by
actual costing, in which actual costs and overhead rates are used;
by normal costing, in which actual material and labor rates are
combined with budgeted overhead rates; or by standard costing,
which employs standard costs for materials, labor, and overhead,
with the differences being charged to variance accounts. With
variable costing, fixed factory overhead is accounted for as an
expense of the period, instead of being charged to the product.

The controversy over
the relative merits of these two methods has extended throughout
most of the history of cost accounting. Adding to the debate is
the fact that absorption costing is the only one recognized by
the Financial Accounting Standards Board (FASB) as acceptable for
externally-published financial statements. Absorption costing is
also required by the Internal Revenue Service in tax preparation.

Variable costing makes
a distinction between variable and fixed costs. The distinction
permitted by variable costing allows the manager to understand
cost behavior at various levels of production. This better
understanding of cost behavior facilitates internal decision
making and is therefore favored by managers. Thus, both systems
will probably continue to be utilized by their respective
constituencies.

The history of
absorption costing is closely linked with the history of cost
accounting. Unfortunately, historical documentation about the
origins of cost accounting is limited due to a fire at the
headquarters of the National Association of Accountants (NAA) in
1984. Many irreplaceable documents were lost in that fire.
Richard Vangermeersch, a leading accounting historian explains
that a problem in cost accounting is that many such accountants
feel that they have no past.(2) Much of
cost accounting is largely confined to use for internal decision
making. With this lack of public scrutiny, cost accountants have
often developed their own systems and methods of accounting,
unconstrained by the generally accepted accounting principles (GAAP)
of financial (externally-based) accounting. Lacking conformity
and public accountability, cost accounting procedures have
frequently been shrouded under a cloak of corporate secrecy. As a
result, there is a lack of documented cost accounting history.

Certain practices and
theories of cost accounting date back to the fourteenth century.
At this time small industrial enterprises started to produce
certain trade items of that era, such as books, woolens, coins,
and wine.(3) The Industrial Revolution brought new developments
in cost accounting systems, but there were no "full-fledged"
systems until near the end of the nineteenth century.(4) Before this time, it was likely that most
manufacturing firms simply modified their accounts to include the
factory charges of direct materials, direct labor and overhead.
Usually no sharp distinction was made between the shop burden (overhead)
and the commercial (selling and administrative) expenses of the
firm.(5) Near the turn of the century, however, cost
accountants began to study the overhead element of cost. At this
point, the debate between absorption and variable costing began.
There was a wide diversity of opinions as to whether overhead
assigned to product should be all-inclusive or very limited.(6)

One of the more
influential persons during the nineteenth century speaking for
the adoption of absorption costing was Alexander Hamilton Church,
who developed the machine-hour method of allocating and applying
fixed costs such as power, land, and building costs.(7) The influence of Church and others like him must
have weighed heavily for the adoption of absorption costing, for
a National Association of Cost Accountants (NACA) Bulletin from
1947 states,

Companies excluding direct labor and
overhead costs from inventory apparently do so because
bookkeeping systems developed some years ago did not
provide for charging these items to inventories and any
change would now involve numerous difficulties. When
certain overhead items only are excluded, the reason
usually seems to be a desire to remove fixed charges from
inventory and gross profit figures.(8)

This statement
indicates that absorption costing was viewed by many as the most
modern, efficient, and accurate method of accounting for product
costs. There were, however, some dissenters, such as Jonathan N.
Harris, who in 1946 remarked

It is unfortunate that the direct-cost
[variable costing] accounting idea has not yet received
general acceptance. If it had come into widespread use
prior to the war, many millions of taxpayers' money and
company funds everywhere might have been saved through
simplification of contract renegotiations, tax returns,
countless reports to the government, and contract-termination
claims.(9)

Harris did not get his
wish, however, as absorption costing was still the favored method
of accounting for product costs in 1953, when Herman C. Hersei
wrote that variable costing could not be expected to replace the
absorption method that was "satisfactorily serving the needs
of most managements at the present time".(10) While the prevalent feeling was against variable
costing, most systems were not using true absorption costing.
According to H. C. Greer, most manufacturers were using some form
of standard costing. Expenses in excess of standard were being
allocated to a production variance account. This total would
ultimately appear as an addition to cost of goods sold.(11)

Along with these
deviations from actual historical absorption costing, variable
costing was growing in acceptance with many manufacturers. In a
1960 survey of approximately four hundred companies in the United
States, The Controllership Foundation reported that twenty-two
percent of the responding companies used direct costing in
internal reporting. Furthermore, the survey showed that two out
of three of these companies had changed from absorption costing
in the previous decade.(12) In
spite of this trend, variable costing was not a generally
accepted accounting practice. Absorption costing, in one of its
three forms--actual, normal, or standard--was the preferred
method of accounting for product costs.

To this day, absorption
costing is the accepted method of inventory valuation for
external reporting purposes. Authors such as Dr. Richard
Vangermeersch are still singing the praises of absorption costing,
saying that the idea of direct costing is "way out of tune
with reality."(13)
Variable costing, while increasing in popularity, remains in use
only for internal purposes.(14)

Alexander Hamilton
Church, who died in 1936, was, in many ways a man ahead of his
time. He believed his machine-hour method of allocating overhead
to be a superior method, especially for a capital-intensive firm.
Church's approach was to treat each machine as if it were an
assembly-line worker, resulting in more accurate cost-usage data
for each machine.(15)
Allocation of overhead costs on the basis of machine hours has
not received much attention in cost accounting practice until
recent years. As companies installed automated manufacturing
facilities, the composition of product costs changed. Computer
integrated manufacturing (CIM) is distinguished by a lack of
assembly line workers (direct manufacturing labor). Accountants
at companies having such installations have begun accounting for
overhead on a machine-hour basis.(16) Direct labor has ceased to be a separate cost
category at many companies.

Church extended his
work on a machine-hour allocation basis into the development of
two ideas often taken for granted today in the manufacturing
world. He originated the concepts of production centers and small
jobs.(17) Cost accounting today is heavily dependent on the
production center concept--treating the department, plant, or
product as an independent entity for accounting purposes. The
concept of small jobs was essential to the development of job
order costing. Job order costing, along with process costing, are
today's primary methods of accounting for manufacturing costs. In
addition, the small job concept is applicable to the automated
factory of today. Automation cam be used to its fullest potential
in the manufacture of small lots of product, as opposed to large,
continuous productions runs of days gone by.

There were other
notable contributions to the foundations of cost accounting as it
is known today. Charles Babbage took the development of cost
accounting systems a step further with his emphasis on
integrating the machine as a part of the management process. In
addition, he emphasized analysis of variance from manufacturing
standards. He believed that proper analysis distinguished a maker
from a manufacturer. The manufacturer was described as one that
worked at reducing product cost to the point where demand could
be met, while a maker merely produced prototypes.(18)

Perhaps the last major
development in cost accounting systems emerged from the practice
and writing of Stanley Henrici, who has been described as the
father of standard costing systems.(19) With these systems, the cost manager can determine
the cost of the product in a more uniform manner without large
price variations due to swings in production volume. Standard
costing complements variance analysis, enabling the manager to
isolate any problem areas.

Modifications in cost
accounting systems are occurring even today. Computer integrated
manufacturing systems are capable of manufacturing a product
without human intervention, eliminating the need for a direct
labor category. Many companies now classify product cost as
direct materials and overhead, eliminating direct labor
altogether.(20) As
mentioned, this development has renewed interest in Church's
machine-hour allocation of overhead, as direct labor often served
as the allocation basis in the past.

A second change in the
manufacturing environment has created changes in how cost
accountants ply their trade. Just-in-time (JIT) inventory and
production systems are based on the Japanese notion that
inventories are evil. The goal of a JIT system is to have the raw
materials delivered to the plant just in time to begin production.
Each stage of production is completed just in time to move it on
to the next stage, and the product is completed just in time for
shipment to the customer.(21) With a
minimum of raw material, work in process, and finished goods
inventories problems regarding inventory valuation and product
costing are greatly simplified. Companies are adapting to this
innovation with a variety of streamlined costing systems.

One of these new
costing systems is activity-based costing (ABC). Under this
approach, each manufacturing cost is linked with the activity
creating the cost. For example, the cost of the purchasing
department can be tied to the number of purchase orders prepared.
Thus, purchasing department costs can be allocated based on
purchased orders issued for various departments.

Cost accounting, with
its lack of generally accepted accounting principles, has not had
the exposure afforded financial accounting. Its history is one of
innovation, methods devised out of necessity. This is good, in
that innovation occurs unconstrained by some idea of "proper
accounting." Yet, this same feature contributes to the lack
of a formal "History of Cost Accounting." Only the best
ideas see the light of public scrutiny and the true sources of
innovations may never be known. Many modifications or innovations
may not be exposed to the public under a cloak of "corporate
security." The history of cost accounting was written, and
continues to be written every day in the factories and offices of
manufacturing America.

ENDNOTES

1. Richard Vangermeerach, "Milestones in the
History of Management Accounting," in Cost Accounting for
the 90's: The Challenge of Technological Change Conference
Proceedings, (Montvale: National Association of Accountants,
1986), 77.